“The biggest risk is not taking any risk.” (Mark Zuckerberg)
So, what is risk, exactly?
Investment risk can be defined as the probability of loss relative to the expected return on any investment. It’s a measure of the level of uncertainty of achieving the returns expected by an investor.
Systematic and unsystematic risk
Investment risk can either be systematic or unsystematic. Systematic risk, or market risk, is the uncertainty that affects the entire market due to external factors. Unsystematic risk is uncertainty that emerges out of controlled variables that are specific to one industry or company.
Common forms of systematic risk include:
Common forms of unsystematic risk include:
Why be risky?
The riskier an investment the greater its potential return in the long run. You as an investor should be rewarded with better returns for taking on additional risk.
Horses for courses
When it comes to selecting your investment, you need to be aware of the amount of time you have in the market and the risk associated with each of the asset classes.
Risk management and diversification
Understanding the relationship between asset classes is key to reducing risk in an investment portfolio. Investments within each asset class move in the same direction during investment cycles. This differs from the way asset classes behave when compared to each other.
Investment diversification is all about combining assets classes which exhibit low or negative correlations and thus move in opposing directions during an investment cycle. It also includes investing in different geographic regions, and in different industries. Diversification minimizes systematic and unsystematic risk, smooths out volatility, and assists to provide consistent returns from a portfolio of investments.
A personal relationship with risk
As well as having insight into asset classes, time frames and the benefits of diversification, you need to consider your risk profile, which comprises:
A happy mix
Your risk profile will determine whether you’re a conservative, moderate or aggressive investor.
At the risk of generalizing, conservative investors are more concerned with preserving their capital and seek to avoid volatility and fluctuations in the value of their capital. A typical portfolio would comprise 50% bonds, 30% cash and 20% equities.
Moderate investors usually want to preserve and grow their capital, while perhaps earning some income too. Moderate portfolios are typically less volatile than the market and may comprise 55% equities, 35% bonds and 10% cash.
Aggressive investors want to grow their capital and are prepared to take on the necessary level of risk. They invest for the long term and accept that the value of their investments will fluctuate over the shorter term. An aggressive portfolio may comprise 85% equities, 10% bonds and 5% cash.
Have your cake and eat it
Investing with specific goals and timeframes means you can be all three types of investor. You might invest aggressively towards your retirement (assuming you’re relatively young), moderately towards your children’s education, and conservatively towards your short-term emergency fund.
Risk – like death and taxes – can never be entirely avoided! But by better understanding both the nature of risk and your risk profile and by taking steps to manage those risks, you put yourself in a far better position to meet your financial goals. Got any questions about risk? Our door is always open.
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